Interview

«We Live in an Environment That is Creating Manias and Bubbles»

Chen Zhao, chief strategist at Canadian research boutique Alpine Macro, cautions not to overestimate the risk of inflation. In his view, he global economy is going through an adjustment process, but the equity bull market continues.

Mark Dittli
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Chen Zhao, Founding Partner and Chief Strategist of Montreal-based Alpine Macro, has been analyzing global financial markets for more than thirty years. Numerous investors worldwide know him as the long-serving former Chief Strategist of BCA Research.

Zhao often has contrarian views, pitting him against the crowd in financial markets. He does not agree with the current widespread fear of rising inflation. «The problem here is that people are not patient», says Zhao. «The global economy is highly out of sync and characterized by shortages. Supply side disruptions take time to play themselves out.»

He believes the rise in long-term bond yields – the yield on ten-year Treasuries has risen from below 1.2% to temporarily over 1.65% within three months – is exaggerated. In an in-depth conversation with The Market NZZ, Zhao comments on his current assessment of the global economy and the severe slowdown in China. Plus, he says where he currently sees the best investment opportunities.

«Central banks can’t do very much in the wake of supply side inflation, unless they shrink the economy. And that would be silly at this stage»: Chen Zhao.

«Central banks can’t do very much in the wake of supply side inflation, unless they shrink the economy. And that would be silly at this stage»: Chen Zhao.

Mr. Zhao, equity markets have gone through a soft patch in September, but are already reaching new highs again. What’s your assessment of the current market environment?

We have to take a step back to see the big picture. The pandemic has caused a very compressed recession with unprecedented depth, followed by a powerful recovery with extremely fast speed. It’s as if a normal economic cycle was compressed into 18 months. Now we are dealing with a resettlement, with economic growth trying to gravitate towards its steady state. This is what is usually referred to as a mid-cycle slowdown and this is where the new problems often start. Today, the world economy is very desynchronized, with the US and China having largely closed their output gaps, but others remain far behind. Right now, multiple factors may cause uncertainty for financial markets: The first is a growth slowdown, the second is rising headline inflation rates due to supply disruptions, and the third is shifting monetary policy.

Let’s start with the growth slowdown. What do you see there?

The Chinese economy was first out of the pandemic and has attempted to settle back into a steady state in early 2021. But since the summer, we have seen an abrupt slowdown, a much harder landing than most people had anticipated. Right now, quarterly sequential growth is near zero, which is unprecedented in China’s recent history.

How about the US and the rest of the world?

We’re getting very mixed signals out of the US. Economic growth must settle back into a lower number, but we don’t quite know yet on what path the US economy will slow down. If you look at the Atlanta Fed Nowcast model, it says the economy has almost ground to a halt during the third quarter. If you look at the purchasing managers index for the manufacturing sector, the economy has also cooled off, but the service sector is bouncing back quickly. Overall, I think that the US economy will slow to 1.5% in the fourth quarter. As for Europe, it is much behind the US. The European economy is still about 5% below its potential pre-Covid trend, so there’s quite some catching up to do. As said: The world economy is very much out of sync.

How long will it take to settle into something like a normal environment?

That’s hard to say, as the pandemic is by no means over. I am glad to see Covid infections have come down in most countries. Booster shots will bring down infections in the future and some drug therapies are very promising too. I think that the world has learned to live with the disease and very soon we will regain some sense of normalcy. Only China pursues a Covid policy that will likely continue to depress its economy because the zero tolerance policy has no exit point.

Why has there been such a hard landing in China’s economy?

In the case of China, the ongoing economic slowdown is definitely more than a mid-cycle phenomenon. I think President Xi is making a mistake by keeping both monetary and fiscal policy way too tight, even to the point of pushing the economy to stagnation.

A clear policy mistake, in your view?

Yes. The People’s Bank of China and fiscal authorities should be stimulating now to counter the effects of this hard landing. Xi is obsessed with deleveraging the economy, but the Chinese economy has a very high savings rate, with the banking sector dominating resource allocation. This means that by nature, the Chinese economy must have a fairly high leverage ratio. Trying to bring down leverage can only cause repeated credit crunches, which has been the root cause of China’s stop-and-go economy in the recent decade. Unfortunately, President Xi is determined to attack credit expansion, and this is why he has pushed the economy to the brink of another growth recession. Authorities have the tools to reflate but will only respond with a lag after deflation intensifies.

The other big topic in past weeks has been rising energy prices. What do you make of that?

This is primarily caused by government climate policies. Policy makers do not understand some deep-seated problems here. Renewables will be able to only satisfy two thirds of the incremental world energy demand in the coming years, whereas the vast amount of the world’s energy needs has to be met by fossil fuels. But now government policy of all major countries has created huge uncertainties for the fossil fuel industry. The ESG movement is creating additional problems because it has driven up capital costs for oil and gas companies, as they are all considered dirty companies. This together has caused the fossil fuel industry’s output to level out globally. Just look at US oil production: The oil rig count stopped responding to the oil price. Who would want to put more money into the oil industry? Germany is shutting down nuclear power plants for fear of another Fukushima accident and this has greatly increased tensions in the natural gas market in Europe. Of course, Russia is also playing politics, as it clearly uses the gas shortage to get leverage for the Nord Stream 2 pipeline. On a positive note, coal prices in China have dropped lately, the energy constraint in the Chinese economy might be starting to ease now.

The combination of rising energy costs and an economic slowdown has caused some commentators to talk about stagflation. Rightly so?

Rising energy costs move the economy to the direction of elevated inflation for a while, but they also put downward pressure on growth. So you could say there are stagflationary forces, but talk about outright stagflation is overblown. When we talk about stagflation, we talk about double digit inflation and an economic contraction, like in the US in the 1970s. I don’t see that happening at all.

Why not?

The US economy is very different from 50 years ago, the energy efficiency today is very high, its manufacturing component is very low. The energy consumption to GDP ratio in 1970 was more than 13%, today it’s less than 5%. Back then, manufacturing was more than 24% of US GDP, today it’s less than 12%. This means the economy can deal with a much bigger oil shock without being hammered. Another crucial difference is the central bank reaction: The Fed tightened policy aggressively both in 1973 and in 1979 to deal with the oil shocks, which greatly added recessionary pressures to business activities and caused two major contractions. To make the situation significantly worse, the Bretton Woods system collapsed in 1971, sending the dollar down by 95% against gold, which was its previous monetary ballast. This currency decline unleashed powerful inflationary pressures, driving up price levels continuously. None of this is happening today.

And yet, we experience stubbornly high inflation rates right now.

The problem here is that people are not patient. The surge has been going on for a few months, and people already cry about inflation. Supply side disruptions take time to play themselves out. We’re still in the middle of a pandemic, where severe disruptions have continued to roil one sector after another. Manufacturing centers around the world are plagued by power shortages and Covid-infections at a time when businesses are scrambling for inventory. However, these abnormal situations will eventually sort themselves out. Remember lumber back in spring? The price went through the roof, and then it crashed by 78%. Then it was semiconductors, coal, used cars, natural gas. The good news is that DRAM prices have fallen by 30% already from their highs. Used car prices dropped by 30%. You have to be patient to let the supply side sort itself out.

Are you not worried about inflation getting entrenched into the system?

No, not yet. The bar is very high to get sustained, high inflation. When we talk about inflation, we are talking about the rate of change of prices, which means the speed of price increases. For the rate of change to stay high, your price level needs to accelerate upward for a long time. That is a very high bar. Remember: You don’t need the price level to drop for inflation rates to drop again. A mere stabilization of the price level will cause inflation rates to drop. The Fed understands this, but the majority of the public apparently may not.

So what we see in terms of inflation is caused by supply side shortages, which is not the kind of inflation that would worry you?

It worries me of course, but the point I try to make is that supply-disruption inspired inflation cannot be cured by either monetary or fiscal policy. No matter how much you tighten your monetary policy, you won’t get more natural gas into the pipelines. Can tight money bring down shipping rates? Of course not. Central banks can’t do very much in the wake of supply side inflation, unless they shrink the economy. And that would be silly at this stage. Central banks are in aggregate demand management. They can’t cure the supply side.

So the current fear of inflation is overblown?

It’s a misguided fear, in my view. If you’re an investor, ask yourself a simple question: Why do we even care about inflation? Because it has policy implications. That’s the main issue. Historically, when inflation was high, interest rates would go up, which would then put stocks and bonds under pressure. So, it’s not inflation per se that might be a cause for concern, but the possible policy response. If central banks understand that the current inflation has nothing to do with monetary policy, why should they raise rates?

The Fed is intent to start its tapering process in November. The market is already pricing in two rate hikes next year. Are you concerned about these policy shifts?

Tapering asset purchases per se is not tightening, it just means injecting less amount of stimulus. I think the Fed should taper and should start the process as soon as possible. However, I’m not convinced that the Fed will be able to raise rates next year, to be honest. My reasoning is this: Let’s assume the US economy will eventually gravitate towards its steady state growth rate of around 1,5% real. Then by this time next year inflation rates could fall much more than people believe because of supply side expansion and inventory restocking today. In other words, into the second half of 2022 you could have a combination of weaker economic growth and lower inflation. Why would the Fed raise rates then?

Do you think it would be a mistake if the Fed tightened monetary policy in this environment?

We saw an interesting market reaction after Andrew Bailey, the Governor of the Bank of England, made a statement that the BoE would soon hike rates to combat inflation. Two year Gilt yields spiked, whereas five year yields rose much less than two year Gilt yields. The result was a very flat yield curve that is flirting with inversion. So the bond market clearly says that this would be the wrong move by the BoE.

Ten year Treasury yields have risen from below 1.2% in August to 1.6% in October. What do you read out of this move?

The US yield curve is quite steep. My interpretation is that the bond market is saying the US economy is growing, the gap between output potential and actual activity is closing. If you look at US GDP versus its potential pre-Covid trend, there is still a gap of 1 to 1.5%, but it’s closing. However, our bond model says the equilibrium fair value of US Treasury yields is only about 1.1 to 1.2%, because the real equilibrium rate, the so-called r-star, is probably quite significantly negative today.

If your model says the fair value of US Treasury yields is 1.1%, yet the market prices them at 1.5% to 1.6%, that would mean it’s time to buy bonds now?

We have begun to add duration when yields reached 1.65% a few days ago. We will continue to do so if Treasury yields keep creeping higher. Today more than 80% of all fund managers are short duration, and they are outright bearish on bonds. I don’t want to be part of that crowd. So from a contrarian perspective it’s probably good to add duration.

What will this environment mean for equities?

The most important thing to realize is that this bull market still has legs. It’s not over. There certainly are a number of challenges, like the mid-cycle slowdown and supply-side disruptions. Plus, the Fed is dialling back its monetary policy at the margin. This combines to a picture where the stock market will probably stop expanding its multiples and stock prices will be moving more or less in line with earnings growth. That’s the right story.

You recently wrote that you fear earnings expectations might still be far too high.

What I predicted two months ago was that the US stock market would flatten out and enter a lateral correction caused by the economic slowdown, which also means earnings growth would slow down. According to our model, if the US economy settles back into 2% growth, earnings growth will slow to the region of 6 to 7%. Right now, the consensus anticipation twelve months out is still 20% growth. There is quite a big gap between what the companies may actually deliver and what the market anticipates today. That makes me a bit cautious in the short term.

We’ve experienced a small correction of a little more than 5% in September, but now markets are clocking in new highs. Is the correction phase over?

This is a tough call. I would have expected the correction to run deeper, but we have to accept a scenario where it might already be over. If you look at the S&P 500 on an equal weighted basis, 90% of the 500 companies have recently experienced a drawdown of at least 10%. That means only 10% of all stocks, some of the heavyweights, have not corrected. If you look at the Value Line Arithmetic Index, which consists of 1700 equal-weighted US stocks, it has been flat for more than five months. Small caps, measured by the Russell 2000, have gone nowhere since late January. If you take this into consideration, we might have to conclude that we have gone through a stealth correction that has already concluded.

What would give you confidence that the corrective phase is indeed over?

The only way to tell is by looking at the broad market. I would want to see the Value Line Arithmetic Index breaking out to the upside. There is no clear evidence of that yet, but I’m watching that very closely. A breakout would be a clear indication that the correction is done and the broad bull market resumes its run.

Where do you see the most interesting fields to invest now?

First, again, the equity bull market is not over. So stay invested. Within equities, I would tend to favor developed markets over emerging markets, because I see the dollar remaining strong. Within developed markets, if my mid-cycle slowdown story plays out, I would favor the US over Europe and Japan, because the latter two are heavy on cyclicals. Growth stocks from the tech sector, even though some of them are richly valued, are still attractive.

You would avoid cyclicals broadly?

The one cyclical sector I would currently overweight is energy. Not on a long term basis, but over the next six to twelve months. Policy makers won’t be going the way of fossil fuels again, but oil prices will stay high, and that’s bullish for the sector in the short term.

What’s your reasoning behind your call for the US tech sector and growth stocks?

We live in an environment that is creating manias and bubbles. In some ways, the environment reminds me of the late Nineties. If you recall, during the second half of the 1990s, corporate profit growth kept slowing, but stocks kept going up. From 96 to 97 to 98 to 99, we’ve had several years of sequential profit slowdown, but stock prices kept making new highs because of all the speculation and a very accommodative monetary policy. Just think what might happen if I’m right and the Fed abandons its hawkish stance next year, once it becomes clear that inflationary pressures subside. This could trigger a mania move to the upside. In this kind of environment, it pays out to stay with the winning markets. Of course, one market you can always watch for mania signs is crypto, because cryptocurrencies have no practical use, they are purely used for speculation.

Chen Zhao

Chen Zhao is Founding Partner and Chief Strategist of Alpine Macro. From 2015 to 2016, he was Co-Director of Macro Research at Brandywine Global Investment Management. Prior to Brandywine Global, Chen spent 23 years at BCA Research. As a Partner, Managing Editor and Chief Global Strategist, Chen developed and wrote BCA’s China and Emerging Markets publications in the 1990s. He became the firm’s Chief Global Strategist in the 2000s and was the author of BCA’s flagship publication, Global Investment Strategy, from 2005 to 2015.
Chen Zhao is Founding Partner and Chief Strategist of Alpine Macro. From 2015 to 2016, he was Co-Director of Macro Research at Brandywine Global Investment Management. Prior to Brandywine Global, Chen spent 23 years at BCA Research. As a Partner, Managing Editor and Chief Global Strategist, Chen developed and wrote BCA’s China and Emerging Markets publications in the 1990s. He became the firm’s Chief Global Strategist in the 2000s and was the author of BCA’s flagship publication, Global Investment Strategy, from 2005 to 2015.